Distributions of Marketable
Securities from Partnerships

By Eugene Gorrin

The GATT legislation created a new IRC section that treats the distribution of marketable securities from a partnership as a distribution of money. The author explains what marketable securities are covered and what exceptions are provided in the law. Tax planning opportunities are also provided.

A significant provision affecting partnerships found its way into law at 1994 year end when President Clinton signed into law the Uruguay Round of the General Agreement on Tariffs and Trade (GATT), which deals primarily with tariff and trade matters. Buried in the ancillary GATT financing legislation is a provision that changes the fundamental tax-free treatment of distributions of marketable securities by partnerships. Under new IRC Sec. 731(c), a distribution of marketable securities is treated as a distribution of money under the general rules applicable to distributions by a partnership to a
partner.

Although the new provision contains a broad definition of marketable security, the exceptions and limitations in the new law should restrict the situations in which partners are required to recognize gain. This new provision impacts partnership tax advice and estate tax planning for partners, particularly family limited partnerships (FLPs) funded wholly or partly with marketable securities. Also impacted will be FLP transactions structured with grantor retained annuity trusts (GRATs) as limited partners where distributions of marketable securities will be made from the FLP to a GRAT to fund all or a portion of the annuity payments to the grantor of the GRAT. A further explanation of FLPs and how they may be structured with GRATs is included as a sidebar to this article.

General Tax Treatment of
Distributions

Under IRC Sec. 731(a), a partner does not recognize gain on a partnership distribution, except to the extent that any money distributed exceeds the adjusted basis of his or her partnership interest immediately before the distribution. Before GATT, the only distributions that would produce gain were actual cash distributions or constructive cash distributions (due to a decrease in a partner's share of partnership liabilities as provided by IRC Sec. 752). Under the general rule, a partner does not recognize gain on a distribution of property, but instead receives a basis in the distributed property equal to 1) the basis of the property in the partnership's hands immediately before such distribution, if the distribution is a nonliquidating distribution or 2) the partner's partnership interest basis if the distribution is a liquidating distribution.

GATT reflects Congress' belief that partnerships were being used to avoid gain recognition when a partnership and its partners elected to distribute the economic equivalent of cash, rather than cash itself, purely to avoid tax consequences.

Operation of New Law

New IRC Sec. 731(c) provides that for purposes of IRC Sec. 731(a)(1) (as well as IRC Sec. 737, which causes a partner to recognize gain if he or she contributes to a partnership property that has a value in excess of its historical basis and then receives within the next five years a distribution of other property), money includes marketable securities taken into account at their fair market value as of the date of distribution. Accordingly, a partner receiving a distribution of marketable securities generally will have to recognize taxable gain equal to the excess, if any, of the fair market value of the securities over the partner's basis in the partnership interest.

The treatment of marketable securities as money applies to distributions subject to IRC Sec. 731(a)(1), such as current distributions and liquidating distributions, including transactions covered by IRC Sec. 737.

The key element in applying the new provision is determining the type of assets that constitute marketable securities. Marketable securities mean financial instruments and foreign currencies that are, as of the date of distribution, actively traded (under the IRC Sec.1092 straddle rules) at the time of distribution. Financial instruments include stocks and other equity interests, evidences of indebtedness (e.g., bonds), options, forward or future contracts, notional principal contracts, and derivatives. Commodities are not included in the definition of marketable securities, except for an interest in a precious metal actively traded as of the date of distribution that is not produced, used, or held in the active conduct of a trade or business by the partnership.

Marketable securities also include a broad collection of instruments designed to embody all kinds of assets closely related to marketable securities. For instance, any interest in a common trust fund or regulated investment company that issues or has outstanding redeemable securities constitutes a marketable security. In addition, marketable securities include any financial instrument readily convertible into, or exchangeable for, money or other marketable securities, including options, regardless of whether the option is readily tradeable. An "in-the-money" option is a marketable security because the option is readily convertible (i.e., sure to be exercised).

Moreover, marketable securities include any financial instrument, the value of which is determined substantially by reference to marketable securities (e.g., index funds). Likewise, privately offered stock, the value of which is determined by reference to actively traded stock of another class of the same issue or another issuer is a marketable security. Marketable securities also include any interest in an entity if substantially all of the entity's assets consist, directly or indirectly, of marketable securities, money, or both (although, as discussed below, an exception exists for interests in investment partnerships).

Exceptions

IRC Sec. 731(c), however, contains several specific exceptions that restrict the application of the new rules to those situations in which the perceived abuse is likely to occur.

Previously Contributed Securities. The first exception prevents the recognition of gain on a distribution of a marketable security originally contributed to the partnership by the distributee partner. This exception, however, does not apply to the extent the value of the distributed security is attributable to marketable securities or money contributed, directly or indirectly, by the partnership to the entity to which the distributed security relates.

Where the original contributing partner of the marketable securities receives a distribution of the same securities contributed, the exception will apply. For this exception to apply to a FLP/GRAT transaction, however, the contributing partner (i.e., the grantor of the GRAT) and the GRAT must be considered as the same partner, so that a distribution of the marketable securities to the GRAT would be considered a distribution to the grantor (the original contributor of the marketable securities to the FLP). In other contexts, a grantor and a grantor trust, such as a qualified personal residence interest trust (QPRT), grantor retained income trust (GRIT), grantor retained unitrust (GRUT) and GRAT, are treated as one and the same person in many different situations. For example, IRC Sec. 1034 rollover treatment and IRC Sec. 121 exclusion treatment are both applicable to the sale of the grantor's principal residence owned by a QPRT (or other grantor trust). In addition, sales of property can take place between a grantor and a grantor trust without gain recognition on the theory that no person can sell property to himself or herself and that in this context the grantor and grantor trust are the same person. Furthermore, a transfer of an installment note by a grantor to his or her grantor trust is not treated as a disposition for purposes of triggering the balance of the gain.

The problem, however, is that there is no definitive answer at this time under this new provision as to whether a contributing partner and his or her GRAT are considered as the same partner. The code and legislative history are silent; there are yet to be any rulings or announcements. It would seem that a contribution of marketable securities to a partnership by a partner, and the subsequent distribution of all or a portion of the marketable securities from the partnership to a GRAT (or other grantor trust) created by the same contributing partner should fall within this exception. In light of the present uncertainty, however, taxpayers should err on the side of caution and not rely on this exception for the FLP/GRAT transaction or any other similar situation.

Previously Unmarketable Securities. To the extent provided in regulations, an exception will exist for securities that were not "marketable" when acquired by the partnership, even if such securities are actively traded at the time of distribution. This provision, however, will apply only "to the extent provided in regulations." The proposed regulations provide that IRC Sec. 731 does not apply to the distribution of a marketable security if 1) the security was not actively traded on the date acquired by the partnership and the entity to which the security relates had no outstanding actively traded securities at the time the security was acquired by the partnership; 2) the security is actively traded as of the date of distribution; and 3) the security was held by the partnership for at least six months before it became actively traded and the security was distributed by the partnership within five years of the date on which the security became actively traded.

Investment Partnership. This exception applies to distributions of marketable securities to a partner if the distributing partnership is an investment partnership and such partner is an eligible partner thereof.

An investment partnership means a partnership that has never been engaged in a trade or business and substantially all of whose assets (by value) have always consisted of certain investment-type assets. (Note: There is as yet no definition of what constitutes substantially all.) Such investment-type assets include a) money; b) stock in a corporation; c) notes, bonds, debentures or other evidences of indebtedness; d) interest rate, currency, or equity notional principal contracts; e) foreign currencies; f) interests in or derivative financial instruments (including options, forward or futures contracts, short positions, and similar financial instruments) in any asset described by any of the other categories above or in any commodity traded on or subject to the rules of a board of trade or commodity exchange; g) other assets specified in future regulations; and h) any combination of the assets set forth above.

To qualify as an investment partnership, a partnership must not be engaged in a trade or business. In this regard, special look-through rules apply. Interests held by a partnership in one or more lower-tier partnerships are generally disregarded, with the upper-tier partnership deemed to own all of the lower-tier partnerships' assets and engaging in all of their activities. In addition, a partner who contributes to a partnership an interest in another partnership will be treated as contributing a proportionate share of the assets of the other partnership.

A partnership will not be treated as engaged in a trade or business by reason of any activity undertaken as an investor, trader, or dealer in the investment-type assets described above. These activities include the receipt of commitment fees, breakup fees, guarantee fees, or director's fees or similar fees that are customary and incidental to an activity regularly carried on by investors, traders, or dealers. In addition, the legislative history states that the provision of reasonable and customary management services to a lower-tier partnership and the provision of incidental services customarily provided to a start-up venture in which the partnership holds a significant equity interest should not cause the partnership to be deemed engaged in a trade or business.

Finally, assuming a partnership qualifies as an investment partnership, the exception is available only to "eligible partners." An eligible partner is any partner who, before the date of the distribution, did not contribute to the partnership any property other than the investment-type assets described above. Qualification as an eligible partner is based on the actions of the person initially holding a specific partnership interest. A partner cannot eliminate the taint of failing to be an eligible partner by transferring his or her partnership interest to another person, unless gain or loss is recognized in whole or in part on the transfer.

This means that a donee of a FLP interest (e.g., a family member or GRAT) gifted from a partner who only contributed investment-type assets (e.g., marketable securities) will qualify as an eligible partner because qualification will be based on the actions of the original holder of the FLP interest.

Gain Limitation. This exception may be a very significant exception for partnerships that hold both investment-type assets and other assets and, for whatever reason, cannot make use of the above three exceptions.

This exception provides a limit on the gain that can be recognized by any partner from a distribution of marketable securities. Under this gain limitation exception, a partner may reduce the amount of marketable securities that constitute money for IRC Sec. 731(a) purposes and thereby reduce the potential recognized gain. This reduction equals the excess (if any) of such partner's distributive share of a) the net gain that would be recognized if all of the partnership's marketable securities of the same class and issuer as the distributed securities were sold (immediately before the distribution) for fair market value, over b) the net gain that is attributable to the marketable securities of the same class and issuer as the distributed securities held by the partnership immediately after the distribution, using the same fair market value.

The exception's intent is to permit a tax-free distribution of marketable securities to the extent of a partner's share of the "built-in gain" attributable to the securities distributed as of the date of the distribution. This exception will allow tax-deferred distributions of marketable securities if made in accordance with the partner's interest in partnership capital. It will also permit tax-deferred distributions of marketable securities in liquidation of a partnership because such distributions will generally be made in accordance with a partner's interest in partnership capital.

For example, assume Partnership XYZ holds 300 shares of A Corp. stock, which is actively traded, plus other assets. Partner X owns a one-third partnership interest. Each share of A Corp. has a $1,000 fair market value and the partnership's basis in each share is $100, resulting in $900 per share of built-in gain ($270,000 total built-in gain). X's adjusted basis in his partnership interest is $50,000, and the partnership distributes all of its A Corp. shares to X in liquidation of X's partnership interest. Under the general rule of IRC Sec. 731(c), the $300,000 value of A Corp. stock is treated as money and X would have a $250,000 gain ($300,000 less $50,000 basis in partnership interest). The gain limitation, however, treats only $210,000 of the A Corp. stock as money ($300,000 value of A Corp. stock reduced by $90,000, which is X's one-third share of the $270,000 built-in gain, which would have been allocated to him by the partnership had it sold all 300 shares of A stock for $300,000). Thus, the gain limitation exception would result in X recognizing only $160,000 of gain under IRC Sec. 731(c) ($210,000 less $50,000 basis in partnership interest).

Taking this example further, assume the partnership instead liquidated and distributed one-third of the A Corp. shares to each of the partners. Under this scenario, X would receive $100,000 worth of X stock (1/3 of $300,000), but the money that X would be treated as receiving would be reduced by the $90,000 of built-in gain that X would be deemed to have received if the partnership had sold all 300 shares of A Corp. stock. Accordingly, the gain limitation exception treats only $10,000 of the A Corp. stock as money ($100,000 value of A Corp. stock reduced by $90,000, which is X's one-third share of the $270,000 built-in gain), and this amount, together with all other cash received by X in the distribution, will be taken into account to determine whether X must recognize gain on the liquidating distribution. If no other cash was received by X in the distribution, X would recognize no gain because the $10,000 of stock treated as money does not exceed X's $50,000 basis in his partnership interest.

The gain limitation exception gives tremendous comfort where FLPs holding investment-type assets and other assets are currently owned 1% or 2% by the older generation and 99% or 98% by the younger generation, and it is contemplated the FLP will liquidate and distribute all of its assets to the younger generation partners after the deaths of the older generation partners.

Basis of Marketable Securities Distributed. In situations where gain is recognized by a partner on a partnership distribution of marketable securities under IRC Sec. 731(c), the gain recognized increases the partner's basis in the marketable securities received. If more than one type of marketable security is distributed to a partner in any given year, the recognized gain is allocated among the distributed marketable securities in proportion to the built-in gain at the time of the distribution.

On the other hand, the adjusted basis of the partner's partnership interest and the partnership's adjusted basis in its remaining assets are determined without regard to any gain recognized pursuant to IRC Sec. 731(c). Therefore, the distributee partner's basis in his or her partnership interest is reduced (in a nonliquidating distribution) by the basis of the distributed marketable securities in the same manner as under IRC Sec. 732.

Regulatory Authority

Treasury is given the authority to issue regulations as may be "necessary or appropriate" to carry out the purposed of the new rules, including regulations to prevent their avoidance. The legislative history provides that these regulations are intended to prevent taxpayers from circumventing the intent of the rules and provide relief from the application of the rules where appropriate. Proposed regulations under IRC Sec. 731(c) were issued on January 2, 1996, and would apply to distributions of marketable securities made on or after December 29, 1995.

The legislative history describes several arrangements to prevent circumvention of the rules, such as arrangements involving changes in partnership allocations and distribution rights, multiple distributions, and related entities, among others. Thus, exceptions to IRC Sec. 731(c) will not be available if the partnership allocations are changed before a distribution to increase a partner's share of marketable securities (resulting in a larger gain being attributable to such partner for purposes of the gain limitation exception), or to achieve the functional equivalent of a distribution (without an actual distribution) by allocating substantially all of the items associated with the security to a particular partner, while decreasing the partner's share of gain from other assets. The proposed regulations provide that a change in partnership allocations or distribution rights with respect to marketable securities may be treated as a distribution of the marketable securities if the change is, in substance, a distribution of the securities.

In addition, the legislative history and proposed regulations address a situation in which a partnership distributes substantially all of its assets other than marketable securities and money to some partners, so that the partnership is left with nothing but marketable securities and money. This technique would have the practical effect of distributing the marketable securities to the remaining partners. Furthermore, the proposed regulations state that if a principal purpose of a transaction is to achieve a tax result inconsistent with the purpose of IRC Sec. 731(c), the IRS can recast the transaction for Federal tax purposes as appropriate to achieve tax results consistent with IRC Sec. 731(c). Whether a tax result is inconsistent with the purpose of IRC Sec. 731(c) is based on the facts and circumstances. Thus, avoiding the new rules through distributions of property in connection with other prearranged transactions, including the purchase of the distributed property, or the creation of "put" rights to dispose of the distributed property at a price substantially above its fair market value might be abusive.

Effective Date

IRC Sec. 731(c) applies to all partnership distributions made after December 8, 1994 (but does not apply to distributions of marketable securities made before 1995 if the partnership at issue held such securities on July 27, 1994). There is no grandfather rule for partnerships formed on or prior to December 8, 1994, except that under a transition rule, IRC Sec. 731(c) does not apply to a partnership distribution of marketable securities in liquidation of a partner's interest if made pursuant to a written contract that was binding on July 15, 1994, and at all times thereafter, so long as the terms of such contract called for the purchase of the partner's interest by a date certain for the fixed value of marketable securities. This transition rule does not apply, however, if the partner has the unilateral right to elect the distribution be made other than in marketable securities.

Accordingly, except for this transition rule, the new rules will apply to all partnerships whether created on or prior to December 8, 1994, or thereafter.

Planning

Although the definition of marketable securities is extremely broad, the exceptions provide a great level of protection for "innocent" taxpayers who wander into the reach of the new provision. They should try to structure transactions on a going forward basis to fall within the exceptions.

Existing Investment Partnerships. For existing partnerships whose assets have always consisted of only investment-type assets, the investment partnership exception will apply and preclude gain recognition on a distribution of marketable securities to an eligible partner. These partnerships in the future should neither acquire noninvestment-type assets nor receive contributions of noninvestment-type assets from partners to prevent falling outside of the investment partnership exception. If a business is desired to be conducted and/or noninvestment-type assets acquired, a separate partnership should be created for such purposes.

New Investment Partnerships. Likewise, for new partnerships to which only investment-type assets such as marketable securities will be contributed, the investment partnership exception will apply and preclude gain recognition on a distribution of marketable securities. These new partnerships in the future should neither acquire noninvestment-type assets nor receive contributions of noninvestment-type assets from partners to prevent falling outside of the investment partnership exception. If a business is desired to be conducted and/or noninvestment-type assets acquired, a separate partnership should be created for such purpose.

FLP/GRAT Arrangements. Similarly, in a FLP/GRAT transaction, where both marketable securities and noninvestment-type assets are proposed to be transferred to a FLP with current distributions of marketable securities made to GRATs, as needed to fund the annuity payments, separate FLPs should be created. One FLP should own only noninvestment-type assets (e.g., business interest), and the other FLP should own the investment-type assets (e.g., marketable securities) to fall within the investment partnership exception.

Existing Partnerships with Investment-Type and Other Assets. For existing partnerships that own both investment-type assets and other assets, however, the investment partnership exception will not be available on a distribution of marketable securities. In addition, distributing the other assets from the partnership will have the effect of a distribution of marketable securities to the remaining partners. Therefore, in those situations where a partnership owns both investment-type and other assets (precluding the investment partnership exception) and wants to distribute marketable securities to a partner, the following analysis should be undertaken:

* Determine whether gain will be recognized on the distribution of marketable securities. (For example, does the value of the marketable securities exceed the basis of the partner's interest in the partnership?)

* If gain will be recognized on a distribution of marketable securities, the distribution should be structured to fall within any one of the remaining exceptions:

* Try to distribute the marketable securities to the partner who previously contributed them (to fall within the previously contributed securities exception).

* If the previously contributed securities exception is not applicable, use the gain limitation exception to reduce the amount of marketable securities that constitutes money and thereby reduce, if not eliminate, the potential recognized gain.

* If gain will still be recognized under the gain limitation exception, the partnership and partners may want to consider distributing assets other than money and marketable securities to a partner since such distributions can be made without gain recognition, subject to the caveat in the legislative history and proposed regulations that this will be treated as a distribution of marketable securities and that anti-abuse regulations may address a situation where a partnership distributes substantially all of its assets other than marketable securities and money to some partners. Therefore, to avoid potential application of an anti-abuse rule, it is advisable in this situation to make sure that a partnership distributes some, but not substantially all, of its assets other than marketable securities and money to some partners. *